Commonwealth Bank – Barefoot Bluechips

Each month I take a look at Barefoot Bluechips and give them a toes up or down Barefoot rating. This month is the Commonwealth Bank of Australia (CBA).

This week the head of the CBA, Sir Ralph Norris told investors that business was getting tougher – while he unveiled a record $6.1 billion annual profit. He may as well have fired the starters gun to bank bashing season:

TV News: And to put that multi-billion dollar profit into perspective for you, it could buy 23,000 Ferraris (awesome, I can’t afford one, but I sure can picture 23,000).

A Current Affair: Outraged customers slam the banks (and then continue paying some of the world’s most expensive fees).

Today Tonight: Tonight we reveal the fat cat bankers’ who are laughing all the way to the…bank.

Tony Abbott: “The bloody banks are screwing me blind!”

One of the earliest investment lessons I learned was that it’s better to own shares in the bank, than it is having your money in a savings account with them. So with that, let’s take a look at the very definition of a blue chip share – the Commonwealth Bank.

The CBA was founded in 1911 by the Labor government of the day. Its first branch was opened in Melbourne in 1912, and then quickly spread across the country.

It was not only Australia’s most dominant bank, but for many years it performed the role of what we now know to be the Reserve Bank.

In the 80s then Federal Treasurer Paul Keating deregulated the market, issuing 17 licenses to foreign banks, in the hope that it would bring competition to the market place.  Yet most got cleaned up in the 1987 share market crash, and by the 1990s the majority had taken their bat and ball and gone home.

That basically left us with the four pillars (Westpac, ANZ, NAB, and CBA). Against the backdrop of the greatest borrowing binge in history, those investors who bought shares in CBA when the Government sold off the company (between 1991 and 1996), made out like bankers.

How do they make their dough?

Historically banking was a pretty boring business; they paid 3 per cent to savers, and then loaned it out to borrowers (that they’d put well through the ringer) at 6 per cent.

Today banks no longer just whack on a margin – they also charge fees; some big, some small, and some apparently illegal, but combined they add up to billions of dollars each year.

Over the years the CBA has used their profits to expand and get a greater share of consumers wallets, buying up businesses like Colonial (funds management), and offering a full suite of financial products like insurance and stockbroking.

It’s often overlooked, but probably the greatest way to profit from the boom was by investing in the boring banks. They’ve been the most sophisticated exploiters of technology, using it to push people out of expensive branches and online. The CBA have even built a robot called Craig James who dispenses economic commentary 24-hours a day to various news broadcasts.

Tell me the good stuff

The CBA is one of the strongest banks in the world – with the bank holding around $89 billion in liquid assets.

The Global Financial Crisis (GFC) was a blessing in disguise for CBA (and the other big three).

Not only did the federal Government pump tens of billions of dollars into punters pockets, but they also guaranteed bank deposits. Better still, the GFC effectively killed off competition from many of those pesky ‘non-bank’ lenders who found themselves unable to access credit from the international markets.

The CBA’s biggest growth driver is its distribution in the marketplace. Roughly half the population does at least some banking with the CBA, with the average customer having about 2.54 products with them. The opportunity to cross-sell each customer more fat fee bank financial products is where the biggest gravy is; just ask any stressed out bank teller who spends their day asking ‘would you like insurance with that?’

Yet underlying the CBA (and the other three pillars) profitability is apathetic customers. Have you ever tried closing a bank account? I once did. Turned out it was easier to break up with my university sweet heart; ‘Why are you doing this?’ ‘Where are you going? Don’t you think it would be easier to keep this account open, and perhaps, you know, one day you might want to come back?

Tell me the bad stuff

A consistent theme for all the banks, including the CBA is that their margins are eroding – a result of increase borrowing costs from overseas markets, and a fierce battle for deposits savings.

We saw how this played out at the start of the GFC: the banks rationed credit and increased their rates independent of the Reserve Bank.

This week the CBA stated that their costs of overseas borrowings could increase by up to 0.4 of 1 per cent next year. And that’s probably a good scenario. If the European banking crisis goes from bad to worse, or the still struggling US flips into a double dip recession, funding costs could increase further still. 

It would then become a political football.

Greens leader Bob Brown has already floated the idea of a Super Profits Tax on the banks.

Another concern, which no one wants to hear, is that CBA have leveraged up on overvalued Australian property. Investment legend Jeremy Grantham (who has studied every financial bubble in history) said recently that Australian housing was ‘a time bomb’, and that to return to normal housing would have to deflate by a mind boggling 42 per cent.

The apocalyptic scenario is that the banks funding costs shoot up because of a further crisis, that causes the Aussie dollar goes down, which in turn makes the cost of carrying that debt much more expensive.

But that probably won’t happen.

A more likely scenario is that consumers will continue to de-leverage, paying down their debts. Politicians will continue their attack on fees; mortgage exit fees, wealth management commissions, together with the current class action on penalty fees.

Toes up or toes down?

If I were going to a stock market party, the CBA wouldn’t be the very first girl I asked to dance. Yet if I owned CBA I wouldn’t be a seller. The company’s return on shareholder equity has historically hovered around 18 per cent (for every $100 invested they have earned around $18).  Add to that a fully franked (tax paid) dividend approaching 5 per cent, and it’s a better return than you get from your savings maximiser account.

Tread your own path!